Monetary Unions and Rules on Public Budgets

We have previously seen (Chap. 2) that, in a monetary union, asymmetric shocks can be faced not only by means of increasing symmetry (in economic structures and institutions) among countries and adequate adjustment mechanisms (price and wage flexibility, labour mobility) but also by means of public or private insurance mechanisms. These are the requirements specified in the Optimal Currency Areas (OCA) theories. The public insurance © The Author(s) 2017

E. Marelli, M. Signorelli, Europe and the Euro, DOI 10.1007/978-3-319-45729-1_4

mechanism concerns the public budget, which ideally should be centralised to a significant extent. This happens in the US but not in the European Union (EU), because the centralised EU budget corresponds to about 1% of gross domestic product (GDP) (see Chap. 1). A second-best solution would be to have public budgets which are decentralised at the national level, but absolutely flexible, in order to counteract the asymmetric shocks by enabling (at least) the automatic stabilisers to operate fully. Nevertheless, this is not the case of the European Economic and Monetary Union (EMU) because some rules on public budgets were introduced at its inception. Why?

One reason is the security of financial conditions, which also requires the sustainability of public debts. It is for this reason that, also in individual countries, legislative or even constitutional rules mandating a balanced budget are frequently introduced to guarantee the solvency of the sovereign states. Such rules, in addition to the ‘market discipline’ (i.e. rising interest rates in highly indebted countries), are intended to prevent opportunistic behaviour by the fiscal authorities.

In monetary unions, there are additional reasons why common rules may be imposed on the public accounts of national governments. The first reason concerns negative spillover effects: a highly indebted country will raise the interest rate also in the other countries of the union, which are compelled - in order to cover the greater service on their debt - to raise taxes or to cut other expenditures. An especially pernicious negative spillover occurs when a country approaches a default situation where ‘contagion’ may hurt the other countries of the union (see Chap. 5 for an illustration of what happened in the Eurozone’s crisis).

A second reason has to do with incentives to create more deficit and debt. Soon after the creation of the union, the likely decrease in interest rates on sovereign bonds (the devaluation risk disappears and only a small default risk remains) may be an incentive for governments - often tempted to follow a short-term management strategy in order to gain electoral support - to extend deficits and debts. A related explanation is that if a country has sustainability problems, it may rely on the aid of other countries, especially if some clauses (like the ‘no bail-out clause’ of the Maastricht Treaty) are not fully credible.

The third issue concerns possible interference in monetary policy decisions. An indebted country may apply pressure on the European Central Bank (ECB) to adopt a more accommodative policy (pressure that may be successful if there are many countries in the same situation), thus undermining its anti-inflation credibility as well.

Before the start of EMU there was a theoretical discussion whether the default risk would be higher or lower after the establishment of monetary unions than before. For example, for McKinnon (1996) default risk would be higher: the impossibility of monetary financing would entail, given the amount of public deficit, an increasing debt and the associated risk of default. On the other hand, other economists maintained that a default would be more unlikely in a monetary union, also because partner countries would aid the country in crisis in order to prevent a contagion; even the ‘no bail-out clause’ of Maastricht Treaty was not initially considered credible (on recent events following the Eurozone debt crisis, see Chap. 5).

As a matter of fact, financial markets considered that default by a member country was entirely unlikely, not only in the early years after the start ofEMU but also in the convergence period before the assessment of Maastricht’s criteria (1998). First of all, the spread between the interest rates paid by the weakest countries in the EU and the German ‘bund’, that in the mid-1990s was still high,¹ in 1997-1998 it impressively decreased and in 1999 reached miniscule figures (less than 30 basis points both in Italy and in Spain). In fact, the devaluation risk had disappeared and the default risk almost vanished.

Many observers wondered why in the first decade after the euro’s introduction, until the 2007-2008 financial crisis, the spreads were so low (about 10-20 basis points in most of the period even for the vulnerable countries), irrespectively of different public accounts conditions. Were financial markets inefficient because they were unable to assess the comparative risk of such different countries? A possible explanation was provided by the ECB (2006) itself: it is the dynamics of the debt/GDP ratio, rather than its static level, that is important for the default risk.² Moreover, in addition to possible changes in accountancy and supervision regulations (including the ECB’s rules concerning collateral’s quality), it was the ‘search for returns’ - in a context of generally low interest rates and calmness in financial markets - that favoured purchases of sovereign bonds with little higher returns. On the contrary, we shall see that after the crises (Chap. 5) there was an over-reaction by the financial markets, characterised by a ‘flight to quality’ and widening spreads.

In any case, according to the orthodox view, this calm situation in the first years of the monetary union was also favoured by the rules on public accounts that were imposed on member countries; such rules guaranteed - apart from specific situations that we shall discuss in the next section - generally low deficits and (slowly) decreasing debts (as ratios to GDP). More generally, it should be highlighted that the substantial absence of significant ‘macroeconomic external shocks’ affecting the Eurozone in that period was also a very favourable circumstance.